"Body Shop" Economics:
What's Good for Our Cars May Be Good for Our Health

Susan Feigenbaum

Susan Feigenbaum is an associate professor
of economics at the University of Missouri-St. Louis and a
visiting scholar at the Center for Study of Public Choice at
George Mason University.

The existence of 35
million uninsured individuals, many of whom are children,
gives ample testimony to the lamentable state of the U.S.
health care system. Less than 40 percent of the below-poverty
population is now covered by Medicaid, despite double-digit
annual growth in program outlays--a clear indication that
medical costs are the driving force behind the problem of
access to care. Those costs must be contained if we are to
address our medical care crisis.

"Solutions" that have preoccupied the public
dialogue--preferred-provider plans, managed care, utilization
review, fee schedules, copayments and deductibles, and
national health insurance--typically assume that to
successfully tame the medical cost leviathan requires
increased cost-sharing and, more important, a curtailment of
consumer and provider choices. Disguised as
"efficiency" reforms that will reduce excessive
provider reimbursement and "unnecessary" care, such
initiatives have been rightly met with skepticism by such
constituencies as labor and the elderly, who foresee the
inevitable erosion of their medical coverage
"entitlements."

In fact, I wish to argue that containing cost at minimum
harm to beneficiaries requires an expansion, not diminution,
of consumer choice. Whereas other approaches seek to assign
providers, insurers, and government agencies the task of
(re)directing health care dollars, it remains a basic
economic principle that consumers are in the best position to
assess the value of services rendered. Critics of a
consumer-based system, who maintain that free choice has
stoked the fires of medical cost inflation, ignore the
central problem: consumers currently bear little of the cost
of their utilization decisions. Indeed, the real culprit is
medical insurance that, by tying reimbursement to services
rendered, has insulated consumers from the opportunity cost
of their health care choices and has created a situation
where the marginal price of care approaches zero. Not
surprisingly, as long as consumers and providers face a zero
price, they will continue to demand a more than socially
optimal amount of "the very best" care.

In a fashion perversely distinct from other insurance
products, medical insurance has generally been unwilling to
divorce payments for adverse health outcomes from services
rendered; moreover, it has relied heavily on direct
reimbursement of providers of care. How did such a
"third-party payer" approach evolve? Why did
medical insurance--insurance against medical care
losses--arise and supplant earlier forms of health (sickness)
insurance--insurance against adverse health events? The
prominent role played by health care professionals in the
design of our medical insurance system suggests that the
resulting explosion in medical care outlays was an
inevitable, if not intentional, consequence of the pursuit of
private interests at public expense.

From "Sickness" Insurance to Medical
Insurance

In the first decades of this century voluntary mutual
societies underwrote large numbers of "sickness"
policies, offering workers a means by which they could
indemnify against income losses due to adverse health events
(much like today's disability insurance). While some
commercial insurers provided similar "sickness"
coverage, the industry focussed primarily on lump-sum payment
policies to underwrite the expense of terminal illness and
subsequent burial. In any case, policy proceeds were fixed
and paid independent of whether ill workers actually
purchased medical services. In fact, only about 1 percent of
the $97 million in sickness benefits paid out in 1914 went
directly for medical care, a reflection of the primitive
state of medicine in reducing morbidity and mortality. Thus,
the original function of health insurance was solely
"income stabilization"--pure insurance against
uncertain, adverse health events.

As technological innovations led to medical interventions
that would significantly improve the quality of life and
longevity, the focus of health insurance shifted from
illness-induced wage losses to medical treatment costs. By
1930 medical expenses generally outstripped wage losses due
to sickness, yet only 10 percent of benefits paid under
then-existing health insurance plans went to treatment costs.
It was not until the late 1930s, when providers themselves
introduced multihospital prepaid "service plans"
(later known as Blue Cross), that the link between insurance
benefits and services rendered was irrevocably forged. Such
plans supplanted "sickness" insurance in favor of
today's medical insurance product. The admitted goal of the
plans was to stimulate demand for hospital services and, at
the same time, reduce payment defaults through
"first-day, first-dollar" prepaid coverage.
Competition among plans was prohibited by American Hospital
Association guidelines; instead, each plan was granted an
exclusive territory. Because member hospitals agreed to
provide services to subscribers regardless of renumeration,
the plans successfully lobbied a majority of states for
enabling acts that exempted them from reserve requirements.
In addition, those acts often stipulated that a majority of
plan directors be nominated by hospitals and that the plans
be given tax-exempt status in recognition of their nonprofit
hospital sponsorship.

Commercial insurers continued to be skeptical of the
actuarial soundness of service plans. They worried about the
lack of liability limits and the "blank check" they
offered policyholders and providers. Nevertheless, motivated
by World War II wage ceilings (fringe benefits were largely
exempt) and lax tax treatment of employer insurance premium
contributions, employers put increasing pressure on insurers
to offer medical coverage as part of their portfolio of
insurance products. With considerable reluctance those
insurers finally opted to offer policies that indemnified
subscribers for medical care losses via lump-sum
reimbursement for specific services. Such indemnity policies
carried fixed limits on insurer liability, required front-end
deductibles and copayments, and excluded many elective
treatments from coverage. Insurers paid insureds directly for
reimbursable expenses (usually the lesser of billed charges
or the payment limit) and left patients liable to medical
providers for services rendered. While the benefits of
indemnity coverage increased with the volume of services
used, the fixed payment limits and cost-sharing requirements
attempted to dampen demand for "unnecessary" and
costly interventions. Thus, as far back as the 1940s,
commercial insurers were grappling with mechanisms to
overcome the dangers of overutilization inherent in
"on-demand" medical coverage.

Still, the regulatory and tax advantages enjoyed by Blue
Cross posed a formidable competitive threat to commercial
insurers and led them to gradually broaden indemnity policy
coverage to more closely resemble a Blue Cross product. While
subscribers still received reimbursement directly from the
insurer, payment limits were relaxed and cost-sharing caps
put into place. At the same time, the federal Medicare
program was likewise evolving into a Blue Cross clone,
reimbursing "participating" providers directly on a
usual and customary fee (physicians) or cost-plus (hospitals)
basis and limiting their ability to balance bill enrollees.
Indeed, it took a decade of double-digit medical care
inflation to embolden Medicare to modify its program design,
resulting in the 1982 adoption of fixed diagnosis-related
payments for hospital care and the 1992 implementation of fee
schedules for physicians' services. Still, providers receive
direct payment and, in a clear effort to appease Medicare's
political constituency, they are severely limited in their
ability to charge patients beyond the deductible and
copayment. Thus, subscribers remain largely insulated from
the cost of medical care and receive little benefit from
cost-effective utilization decisions. Moreover, the problem
of "moral hazard" among providers has led to volume
increases in the form of hospital readmissions and elective
procedures as well as service redefinitions that
substantially inflate reimbursement levels.

A Return to Sound Insurance Principles

As the dangers foreseen early on by the commercial
insurance community become reality in the 1990s, it is time
we reconsider the incestuous link between medical insurance
and medical providers. While property insurers divorce
insurance settlements from actual costs incurred--for
example, automobile insurers pay claims independent of repair
costs in any given instance--such a system has yet to be
considered for medical insurance. The separation of insurance
payments from services rendered would reintroduce into the
medical care industry the most fundamental prerequisite for a
well-functioning market: a price-sensitive consumer. To
illustrate the point, consider the case of automobile
insurance.

In the event of a collision, an insured receives an
appraisal of damages, provided directly by insurance company
appraisers or through submission of multiple repair
estimates. Claims adjusters typically guarantee that
settlements (less deductible) are sufficient to complete
repair if an insurer-approved mechanic is used. Once the
appraisal is accepted by both the insurer and insured, the
claim is paid, which fulfills the insurance company's
contractual obligation. Insurers compete for market share not
only through premiums and coverage, but also through the
ease, accuracy, and convenience of their appraisal systems.
Once a claim has been settled, an automobile owner enjoys
complete freedom of choice in selecting a repair shop. A
savvy shopper of repair services may be able to repair his
car and have money left over for other purposes. Thus, the
insured party enjoys the full benefit of price-consciousness
and, yet, bears the full opportunity cost of repair.

How could this scenario be extended to the medical
insurance market? Currently, subscribers bear little cost of
utilizing medical resources; even the existing cost-share
components are often capped in any given policy year or are
offset through supplemental major medical or
"medigap" insurance. Since providers are reimbursed
the lesser of billed charges or a fixed payment limit,
patients are denied any benefit as "residual
claimants" from lower cost utilization choices. In fact,
to receive insurance benefits, one is often required to make
cost-maximizing service choices; thus, for example, hospital
services are reimbursable while lower-cost home health
services and hospices often are not.

To create the same incentives in medical insurance as
exist in property insurance requires the reintroduction of
"sickness" insurance--conventional indemnity
policies, with fixed payments made directly to subscribers
per episode of illness (or per unit of care), independent of
the resulting type or level of medical expenditure. Chronic
illnesses could be indemnified on a "per unit of
time" basis rather than per episode, thereby preserving
the separation of payment from actual resources consumed.
Identical cases would elicit identical payment, not
necessarily identical medical care: given freedom of choice,
individuals would now have the opportunity to supplement or
use less than their full indemnity payment, thereby
internalizing the full marginal cost of care. And, while the
current system of copayments, deductibles, and allowable
charges virtually assures "out-of-pocket" outlays,
indemnity policies offer the real possibility of complete
coverage for those who behave economically.

How might this new system be operationalized? Before
seeking medical care, a subscriber's insurance company would
conduct claims "appraisals" based on diagnostic and
treatment cost information generated in-house or supplied by
outside diagnosticians. In this way diagnosis would be
separated from subsequent treatment. Insurers would guarantee
that their settlement would be accepted as payment in full by
contracted preferred providers. The ability of insurance
companies to act as appraisers is not so far-fetched:
currently, precertification and utilization review programs
require that medical care needs be assessed before actual
receipt of care, except in a medical emergency. Moreover,
Medicare already "subcontracts" its appraisal work
to the medical community, reimbursing hospital providers
according to the diagnosis-related group category to which
the patient is assigned, independent of actual treatment
costs. Earlier studies have noted that the on-going
development of sophisticated patient classification systems
for prospective payment purposes provides a natural vehicle
by which claims can be classified for the purposes of medical
indemnification.

Indeed, the critical difference between the current system
and what I propose here is that by paying insureds directly,
diagnosis is divorced from the ensuing medical care, thereby
reducing moral hazard on the part of providers and allowing
subscribers to benefit from acting as prudent purchasers.
Thus, policyholders and insurers become partners in their
efforts to hold down medical costs through comparison
shopping for price and quality and conserve health care
dollars that can be redirected to coverage of the uninsured
population. Other researchers have suggested that the
Medicaid program would enjoy significant budget savings if
beneficiaries were offered medical care vouchers that, when
used to purchase care from low-cost providers, would entitle
them to a share of the cost-savings accruing to the program.

Even the medical establishment could benefit from such an
overhaul of medical insurance. Providers would be freed of
burdensome price controls and could therefore provide a
fuller range of services in response to patient demand. Thus,
while one patient might opt for outpatient cataract surgery
and home recuperation (the current Medicare standard of
care), another might prefer to supplement his Medicare
indemnity and stay overnight for observation, an option
currently precluded by balance-billing rules. Consumers who
chose to be treated at a higher-cost hospital closer to home
could do so, albeit at higher out-of-pocket expense.
Hospitals would no longer be forced to compete solely on
service dimensions, such as elaborate birthing suites or
private rooms, but could now compete in both price and
lower-cost service options, such as inpatient spousal care.
Finally, providers would be freed from the whims of public
and private insurance monopsonies, which have engaged
increasingly in price-cutting, quantity-limiting, and,
arguably, quality-reducing activities to achieve short-term
budget objectives. Mark Pauly has cogently argued that there
is little assurance that the market power of medical insurers
will be used to promote economic efficiency through cost
containment rather than to impede efficiency through
cost-shifting or limiting access.

Providers would now hold all patients directly liable for
payment (in the form of indemnity vouchers or cash
supplement) and would thereby reduce administrative costs
associated with cumbersome and costly billing requirements of
government and private insurers. Providers could choose to
take "assignment" by adopting the insurer's fee
schedule, forgive deductibles (currently prohibited by
Medicare), or balance bill patients, waiving that right only
upon mutual agreement with the insurer. Price-sensitive
consumers would force higher-priced providers to justify
their charges with information on quality of care and
goodness of outcomes and would thereby improve market
differentiation of more severe and complex cases. Obviously,
the role of licensure becomes exceedingly important in
assuring patients a "floor" of service quality, and
insurers will likely continue to compete on the breadth and
quality of services covered.

A recognized bias in the current medical insurance system
is its implicit subsidy of risk-taking in lifestyle choices.
Illness prevention activities such as exercise programs and
health screenings (for example, mammography) are often
excluded from insurance coverage. Moreover, the prevalence of
uniform insurance premiums within employer groups results in
individual premiums that do not reflect individual health
risks. Yet, conservative estimates indicate that over 18
percent of employees' medical insurance claims can be
directly attributable to controllable and measurable
lifestyle risk factors. To encourage an optimal level of
self-insurance, an indemnity plan could easily accommodate a
contributory negligence standard, whereby settlements are
adjusted to penalize policyholders for socially unacceptable
lifestyle risks. Such an approach might be particularly
attractive if the resulting savings in indemnity payments
were used to expand coverage for cost-effective prevention
activities such as health screenings. The introduction of a
contributory negligence standard would also go far in
dampening "moral hazard" among
policyholders--discouraging self-induced and fraudulent
claims, a problem that threatens virtually all insurance
markets, including automobile and property. While the debate
rages among medical ethicists over whether alcoholics ought
to be discriminated against in the rationing of scarce
kidneys for transplantation, perhaps that dialogue should be
extended to the ethics of rationing scarce public and private
insurance dollars on the basis of lifestyle choices.

Opting out of Medical Care: An Option?

Encouraging patients to become prudent purchasers would
undoubtedly promote cost efficiency, reduce growth in medical
care inflation, and free up financing for greater access to
care. Unfortunately, however, any system that requires an
individual to follow a prescribed course of care to receive
insurance benefits continues to distort choice in favor of
covered medical services and away from other consumption or
investment alternatives. Recall the automobile insurance
analogy. Subscribers there have the option of deciding not to
purchase any repair services at all. A medical indemnity plan
that divorces payment from services rendered has the
potential for imposing upon insureds the full cost of not
only utilizing high- versus low-cost care, but, perhaps more
important, consuming medical versus nonmedical resources.

In reality, an indemnity plan that requires subscribers to
purchase care for their illness with insurance proceeds can
be difficult to monitor and enforce in many instances. How
much care is enough? When does prudent purchasing give way to
"insufficient" care? Obviously, when patients
desire to purchase minimal or no medical care with their
insurance settlement, competitive providers will have an
incentive to exploit the "gains from trade" by
reducing service quality or intensity along with price. Are
there situations where society might see fit to permit
patients to spend indemnity settlements on nonmedical
pursuits? Are the ethical dimensions of allowing individuals
to refuse care different from those arising when individuals
are encouraged to opt out of medical insurance altogether (a
route being pursued by a number of private and local
government employers)? What are the implications for the
level and mix of medical services utilized?

When one realizes that almost 30 percent of the Medicare
budget is spent on acute care during an individual's last
year of life and that an alarmingly high fraction of Medicaid
outlays pays for nursing home care, one suspects that the
same dollars put in the hands of the ill might be spent in a
substantially different way. Quite likely, a legion of
"prudent purchasers" would arise, each making a
personal, and often painful, decision concerning the relative
merits of medical services versus other
"quality-of-life" needs (the education of their
children and grandchildren, for example). Individuals would
scrutinize the relative costs and benefits of medical care,
thereby creating pressure on providers for more
cost-effective treatments and consumer information.
Palliative approaches to terminal illness (for example,
through the hospice movement) would no longer be the
stepchild to expensive, acute care interventions. Patients
would be encouraged in their use of lower-cost treatment
settings, which would lead to a long-belated recognition of
the role of family care givers. Indeed, innovative long-term
care insurance offered by the Golden Rule Company provides a
"cash value" option that permits the policyholder's
family to benefit monetarily when it chooses to provide home
care (a choice greatly favored by the elderly).

To allow patients to opt out of care found warranted and
reimbursable by insurers raises new administrative issues.
Beneficiaries must bear the full cost of their decision to
seek or reject medical treatment: the choice not to purchase
care today cannot later be mitigated by appeal to public or
private insurance or subsidy programs tomorrow. While the
decision to refuse treatment may be revoked at any time, the
individual must then bear the subsequent cost of medical
care. Just as providers are currently required to obtain
informed consent for recommended procedures, they would be
required to obtain informed consent concerning the health
implications of refusing recommended treatment. Thus,
"downstream" hazards related to today's allocation
of indemnity payments would be fully internalized in the
decision process.

Clearly, there will be instances when it may be
appropriate to demand that an insurance settlement be
dedicated in its entirety to medical care. In such situations
medical expense vouchers, redeemable by licensed service
providers, will facilitate compliance. Thus, for example,
public health needs require that treatment for infectious
disease be mandatory. Moreover, concerns about the quality of
parental decisions might lead to the requirement that all
pediatric-related settlements take the form of vouchers.
Terminally ill individuals may be permitted to "cash
in" acute medical care benefits but be required to
retain hospice coverage. (Indeed, Medicare already offers
subscribers the option of substituting hospice services for
acute care coverage.) Certainly, individuals unable to make
choices in a competent fashion--children, the mentally ill,
and terminally ill, unconscious patients--would require
sufficient protections to avoid exploitation of their
indemnity payments by legal guardians. "Living
wills" provide an important vehicle by which one can
"forward contract" future choices (or choice of
guardian) to be enforced during any period of incompetency.

The biggest impediment to engineering such a radical
departure from current insurance regimes is that it requires
us to empower individuals rather than medical care providers
to determine their medical care needs. Potentially, it could
also grant individuals the freedom to trade medical services
for other personal priorities. The moral dilemma implied here
is little more than a red herring once one considers the
looming alternative--government rationing through fee
schedules, managed care, and national health insurance. While
such approaches would reduce medical care coverage
surreptitiously by limiting access and choice, a
"cash-value" indemnity plan would require Congress
to define explicitly the limits of publicly financed medical
care rights--how much and for whom? Thus, even policymakers
could be made to bear the cost of their life-and-health
tragic decisions.

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